I’ve been reading a book called The Bankers’ New Clothes by Anat Admati and Martin Hellwig, which is essential reading for anyone wanting to understand banks. Jargon-free and easy to read, it was described by the FT’s Chief Economics Correspondent Martin Wolf as “the most important [book] to emerge from the crisis.” He may be right. Here’s a good reviewer’s summary of its core arguments.

I want to highlight a short section from the book, which effectively restates one of the key components of our recent Finance Curse analysis, in a way that connects our analysis with some foundational economics literature.

First, to restate: the Finance Curse analysis notes that in finance-dependent countries — as with natural resource-dependent countries — the dominant sector tends to pay higher salaries and suck the best people and resources out of alternative economic sectors, thus harming those alternatives. As a Bank for International Settlements paper recently summarised it, alongside plenty of empirical evidence:

“Finance literally bids rocket scientists away from the satellite industry. The result is that erstwhile scientists, people who in another age dreamt of curing cancer or flying to Mars, today dream of becoming hedge fund managers.”

This particular aspect of crowding-out is one of a range of harms that flows from having an oversized financial centre. Oversized finance “competes” with other economic sectors and often harms them.

Now on the subject of ‘competition’, a first quote from The Bankers’ New Clothes to put this into a global context (here I’ve condensed the original down somewhat):

“In the global economy, different industries are interrelated and it is not possible for a country to win the competition in all industries at the same time.”

Specializing and doing something well necessarily means not being as good at other things, and nobody is worse for it. For example, doctors specialize in medical practice, and they are happy to get their strawberries from a farmer.

This logic also applies to international trade. Politicians sometimes talk about countries being in competition with each other. This is a flawed argument. If financial institutions in the United Kingdom or Switzerland have leading positions in global financial markets, their successes are directly related to the inability of their countries’ firms to compete in other activities.

Banks in a country are not just competing with banks in their own country. Most importantly, they are competing for people, particularly those with scarce talents, whom firms in other industries would also like to hire. If the other industries cannot afford to pay high enough salaries, they do less well in competing for people. Consequently, they may not do as well in selling their products or services, either locally or globally.

Unless the market system is distorted, a firm’s success in its markets is a sign tha the firm’s use of the talent and other resources it acquires is good for the global economy.”

My emphasis in bold.

The authors mention in a footnote that this is a way of talking about David Ricardo’s two hundred year old theory of competitive advantage, a classic of the economics literature (to see what this is, the clearest explanation I could find is this one. )

But there’s more to be said — particularly in light of that above qualifier in bold “unless the market system is distorted.” Admati and Hellwig continue:

“For the people in the country, the important question is whether resources — most importantly people — find their most productive uses. Might those smart people in investment banking be more productive in developing new software?

Nobody can answer such questions directly. An indirect way to find out is to see which firms win in competing for people. If markets work well, the most productive firms will best be able to attract talented people.”

When it comes to finance, though, do markets actually work well?

I think most people would answer that question with a resounding no. That’s for several reasons. For one thing, banks are subsidised by the public. They can take risks at others’ expense: taking the cream in good times, and shoveling the costs onto others when their risky chickens come home to roost – as with the bank bailouts in the financial crisis. What’s good for banks often harms society. Similarly, a company that pollutes a river and doesn’t pay for the damage may be a world leader in its markets because it has cut its costs, but that does not mean that this outcome is beneficial to society. Continuing:

“Subsidized firms are likely to attract too many resources and to be more successful than is good for society. This also holds if the subsidies support firms’ successes in global markets. Even if regulations reduce the ability of the affected institutions to compete in global markets, society may be better off. If banks are less successful in global markets, the available talent and other resources will be attracted by other industries.”

Quite so. And still, that’s not all. There are various other subsidies to finance.

“The UK’s laxity, however chaotic and crude, is the way it earns its living. This is not a country able to trade on world-beating productivity or infrastructure.”

Britain’s comparative advantage – it’s ‘competitiveness’, in the words of bank lobbyists — lies substantially in its ability to race faster to the bottom than other nations.

This makes it a rather toxic centre in many respects, not just for the world, but for the local economy too. In light of all these distortions, Ricardo’s theory simply falls apart for the City of London – and indeed for the entire global offshore system.

4 comments so far

The book you mention seems to get banking plain wrong, if the reviewer you cite is anythign to go by. In particular:
” In order to make $100 of loans, a typical bank borrows $97—from depositors, from money-market funds, from other banks, or from bondholders—and sells $3 of stock.”

No! A bank creates the money in a borrower’s account, accounting the loaned money as a liability and the debt to the bank as an asset. This is simply a documented fact of how banks operate, and failure to grasp this is pretty inexcusable. Its loan is “backed” by relatively small holdings equity, which is why if the banks’ assets fall in value by a small amount they become technically insolvent. See. e.g. “What is Money?” by Richard Werner et al, and citations there to bank of england documentation.

Nick Shaxson6th June, 20138.33 am

As I remember, the book doesn’t make that particular argument in that way: I think that particular formulation comes from the reviewer.

Bank Analyst6th June, 201312.06 pm

Nick B.
Bank Loans = assets,
Bank deposits and wholesale funding = liabilities.
The point is that equity is a tiny proportion of EITHER total assets or total liabilities. And this leverage allows banks to benefit from a public guarantee of their liabilities.